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Foolish Fundamentals: Margins

If you want an edge in investing, you have to be able to think beyond the usual.

Traditionally, margins represent the efficiency by which companies capture portions of sales dollars. But that focus is too narrow. Margins can provide much more information.

The traditional lensExperienced investors can skip this part. But for the less-experienced folks, a few definitions are in order:

Gross margin equals gross profit divided by sales. It indicates how well management is using labor and materials to support the business.

Operating margin equals operating income divided by sales. This is one way to show how well management is running the business.

Net margin equals net income divided by sales. This is the bottom line, or the amount of money left after all expenses are paid.

Margins look at how much a company gets from each sales dollar after accounting for certain expenses. But let's go deeper.

The fuel lensOne way to think about gross margins is fuel. Gross margins power the operating decisions that a company makes. Typically, higher gross margins give companies flexibility in their operating decisions. And that's a good thing to use when comparing competitors. Below are 3M's (NYSE:MMM) historical margins.

Metric

2000

2001

2002

2003

2004

Gross Margin %

47.4%

45.5%

48.7%

49.1%

50.2%

Operating Margin %

18.3%

14.2%

18.7%

20.4%

22.9%

Net Margin %

10.7%

8.9%

12.1%

13.2%

14.9%

Philip Durell understands what these margins mean to 3M. When recommending 3M for The Motley Fool's Inside Value newsletter service, Philip broke down operating income growth and operating margins by business unit to show just how strong a company 3M is.

And more importantly, Philip understands that those gross margins fuel 3M's world-renowned innovation engine. Without them, 3M would not enjoy its competitive advantages, nor would it create as much value as it does.

The power lensTaking a page from evolutionary biology, the powerful survive and control the environment, while the efficient are relegated to their niches. Sure, efficiency is important along the way, but power is required to survive and get stronger in the face of intense competition.

As with Amazon.com, gross margin percentages at Overstock are relatively flat and not very large. In fact, CEO Patrick Byrne wants to maintain gross margins at near 15% to keep customers loyal, since it's cheaper to keep customers than to acquire them. (See "The psychology lens" below.) And operating and net margins are essentially breakeven. But notice how gross margin dollars are growing rapidly. That's pure power that's enabled Overstock.com to build its brand, grow customer loyalty, and try new ideas -- like auctions.

Again, power (dollars), not efficiency (percentages), makes Overstock.com a force to be reckoned with over time.

But there is risk in this model, however -- management risk. As an investor, you need to have confidence that management can execute the plan to sacrifice near-term profitability for long-term value creation.

The psychology lensAlthough this may seem like a stretch, margins can actually create powerful incentives for people.

Costco(NASDAQ:COST) caps its gross margins at 14% for most items and 15% for private-label products for two reasons: to attract and keep customers shopping in its stores, and to align the behaviors of all of its employees toward serving customers and controlling costs.

Tom Gardner recognized this strategy when he recommended Costco for Stock Advisor. As a Costco customer, Tom knows he's getting a great price. And Costco employees know that to create value, they have to serve customers as well and as cheaply as possible.

From the numbers below, we see that gross margins are low, which brings in lots of new customers and keeps membership renewal rates at more than 85%. And excellent cost control generates more and more free cash flow over time.

Metric

2000

2001

2002

2003

2004

Gross Margin %

11.9%

12.1%

12.3%

12.5%

12.5%

Cash from Operations (millions)

$1,070.4

$1,032.6

$1,018.2

$1,507.2

$2,098.8

Capital Expenditure (millions)

$1,228.4

$1,447.5

$1,038.6

$810.7

$705.6

Free Cash Flow* (millions)

($158.0)

($414.9)

($20.4)

$696.5

$1,393.2

*Free cash flow equals cash from operations minus capital spending.

Costco's gross margin strategy is the glue that binds the employees to the customers and creates lots of value.

The Foolish bottom lineMargins are important. But how you use margin information is more important to your investing success. So don't stay on the surface when analyzing margins. Your portfolio will thank you for it later.

Thinking deeper about margins will make you a better investor. Fortunately, Philip, David, and Tom understand this. Take a peek at Inside Value, Rule Breakers, and Stock Advisor, which has recommended Amazon.com. You have everything to gain and nothing to lose because the trials are free.

David Meier, Shruti Basavaraj, and Adrian Rush contributed to this article.